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Rising oil prices, uncertainty over liquidity control measures hit bonds

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Banks flooded with deposit flows; treasury incomes set to improve

C. Shivkumar

Bangalore, July 29 Bonds reversed their three week gains on advancing oil prices and uncertainty over liquidity control measures at the Reserve Bank’s monetary policy review next week.

But traders said FII unwinding of equity positions triggered a retreat in bonds. Besides, FIIs found the current situation favourable since both equity prices and exchange rate have appreciated.

Oil price spike also hit bonds. Oil prices are currently close to $78 a barrel, taking the weighted average import prices close to about $72. With no domestic price revisions in the offing, oil companies have activated their credit lines for funding their import requirements.

This resulted in the dollar moving down to Rs 40.52 and forward premia at the short end firming close to one per cent for the 30 days, last week.

The previous week, it was level. But 3, 6 and 12 months remained soft at under 1.5 per cent. The softness at the medium and long ends was largely on account capital account, debt and non-debt inflows, particularly from external commercial borrowers.

The RBI’s foreign exchange market interventions contributed to the surfeit of liquidity as some of the ECB borrowers have begun repatriating project funds. Besides, deposit flows into the banking system remained strong, leading to a liquidity overhang, growing at close to 25 per cent. Banks are also being flooded with deposits from non-resident Indians in view of the exchange rate differentials. This has lead to accretions in deposits. As a result, time deposits this financial year have grown to Rs 4.62 lakh crore or 52 per cent over the corresponding period of the previous year.

LAF auctions

The liquidity overhang was reflected at the liquidity adjustment facility (LAF) auctions. At the two weekly LAF auctions, banks continued their recourse to the reverse repurchase window. The combined bids at the LAF auctions for reverse repos amounted to Rs 1.52 lakh crore.

Faced with these inflows, and the Rs 3,000-crore cap on reverse repos, the weekly 91-day Treasury bill yields, at the auction last week, dropped to 4.46 per cent, the lowest level since June 2004 and down from the previous week’s level of 4.5 per cent. The weighted yields dropped to 4.33 per cent. Bids amounted to Rs 6,468 crore though only Rs 2,000 crore was accepted. This was despite the Rs 2,000-crore auctions of the market stabilisation scheme securities through issue of 7.55 per cent 2010 bonds at a yield to maturity of 7.04 per cent.

The low cut-off yields triggered speculation of a steep drop in the reverse repo rate next week. Similarly, at the 182 day T-bills auction, the yields were 5.82 per cent, though it was about 136 basis points above the 91 day T-bills indicating a preference for the latter.

But the turmoil in the equity markets towards the weekend and consequent FII unwinding pulled down the 10-year YTM on a weighted average basis to 7.82 per cent from the previous week’s 7.77 per cent.

Trade volumes

Daily trade volumes remained high at Rs 8,000 crore per day at the Clearing Corporation of India’s electronic counter, though lower than the previous week’s average of Rs 9,500 crore.

Yield spreads between one and 29 years widened further to 190 basis points in view of sinking short-term yields. Moreover, long-term yields have widened, in view of low buying interest. In fact, yields at the long end have seen very little volatility during the last few weeks.

This was also because insurance companies, in particular LIC, have remained inactive preferring the primary market. Some switches and outright selling of short-term securities though were made, particularly the 9.39 per cent 2011, taking advantage of the current liquidity situation.

Despite the positive outlook, there were still some losses. Some primary dealers, foreign and private sector banks which had picked up 7.55 per cent 2010 security at around 7.04 per cent incurred losses when it slumped to 7.13 per cent towards the weekend. But, such aberrations apart, fundamentals were still favourable. One-year real yield was slightly above 2 per cent well above the internationally accepted levels of a 1.5 per cent.

Besides, funds were also coming in from some of the initial public offerings, all of which are expected to find their way into the surge in liquidity in the coming weeks. The situation will help the banks improve treasury incomes and offset the fall in credit. The Canara Bank Chairman and Managing Director, Mr M.B.N. Rao, said, “It is good for the banks and will help in improving treasury incomes.”

In fact, treasury incomes would come in handy for banks, as net interest margins have dropped sharply on account of the credit slowdown. In Q1, NIMs for some of the large banks had dropped to 2.5 per cent down, at least 60 basis points over the last year. This was likely to show up in the second quarter as well, if the current trend continued. Incremental credit deposit ratios were just 40 per cent.

Despite this low ratio, bankers still preferred to stay at the shorter end of the yield spectrum — they prefer to remain derisked.

The surfeit of liquidity notwithstanding, bankers still prefer to remain liquid rather than moving into investments. Incremental investment deposit ratios were just 20 per cent.

Cash to deposit ratios was 42 per cent last week indicative of the liquidity preference. Bankers believe that given this situation the credit policy review would provide the impetus for a credit push, rather than monetary tightening.

(This article was published in the Business Line print edition dated July 30, 2007)
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